Digging up the unloved pays off in spades

Q: What changes have you made to the fund since taking over from Scott McKenzie in August last year?

A: One of the main reasons I took over the fund in August, which at the time was on an interim basis, was that I had a similar investment style to Scott and knew the portfolio well. Before taking over I had worked as Scott’s deputy on the fund for two years.

The style both myself and Scott follow can be described as a contrarian investment philosophy, which puts the fund firmly in the value camp. The fund looks for stocks that are unloved by the market for one reason or another. This could be either because they are underperforming operationally, or because they are in a sector that is out of favour with the market.

As a result there has not been a lot of immediate turnover. I have bought only four or five companies since taking over and sold a similar number. The number of stocks in the fund is broadly the same.

Q: Which stocks have you bought?

A: One example of my own idea going into the fund is BAA, which I added to the portfolio in the last quarter of last year. I actually did not expect it to perform as well as it has done, with performance fuelled by ongoing bid activity from the Spanish construction company Ferrovial.

BAA is a company with a fantastic franchise running UK airports, with a monopoly on the London airports. Other stocks I have added include Collins Stewart, Mytravel and AstraZeneca.

Q: At the end of February it was announced you were to become the lead manager of the fund, partly on the grounds of strong performance. What was behind this good performance?

A: Looking over the period of the last quarter of last year and the first quarter of 2006, most of the performance has been down to stock-specific factors. It is important to note that no big macroeconomic themes are forced into this fund; neither are big sector positions. BAA and the platinum miner Lonmin have both contributed to returns, with Lonmin up 54% on a relative basis in the first quarter this year.

Other stocks that have done well are Alliance & Leicester and Collins Stewart. The fund has also been a big beneficiary of the large amount of M&A activity in the market over the past six months. The fund held Virgin Mobile, which was taken over by NTL.

Q: Do you expect the M&A activity to continue going forward?

A: Yes, but I think the focus of it will change slightly. So far private equity companies have been behind a large number of the bids taking place; going forward I expect the corporates to get more involved. When looking for takeover targets, private equity companies tend to just look for undervalued companies; as the corporates get involved, the focus will switch more to strategic assets.

Q: Your investment process dictates that you look for companies that are out of favour with the market. What companies fit this description at the moment?

A: Aside from those individual names I have already mentioned, the big picture is that a lot of the large/mega-cap British companies look undervalued. A lot of this fits in with what is going on with M&A. Because there is so much M&A activity around at the moment, a number of people are placing bets on what the next M&A targets will be.

As most M&A targets tend to be further down the market-cap scale, this means they are taking money out of their large-cap holdings to fund these bets. While this is not the only factor causing the undervaluation, at present a number of the mega caps, including Vodafone, BP and HSBC, all look quite cheap relative to where they have traded historically.

As a result I have increased the fund’s exposure to large-cap companies. In August, when I took over the fund, 63% of the portfolio was invested in the FTSE 100; this has since risen to 68%.

Q: How many stocks are there in the fund?

A: The portfolio will tend to invest in 50-60 companies, with the average holding size being 2%. While I do try to be index aware, the fund is not constrained by the index. If I like a stock I will put it in the fund; if I don’t, I won’t. The size of holdings ranges from 1-5%, but no stocks are bought above 5%.

Q: How do you pick stocks for the fund?

A: I use a screen that I actually developed myself. I look at a standard value matrix, which analyses yields, price-earnings multiples and book multiples. I also use an operational matrix, which looks at factors such as a company’s operating margins and balance sheet strength.

Importantly, when looking at these two matrices, I consider them in terms of where they have traded historically. Looking at cross cycles of periods of 10-15 years allows you to see whether the margins and returns the businesses are generating will be sustainable.

Meeting companies is also important. I see every company held in the portfolio at least once a year and meet around 150 companies a year.

Q: What risk controls do you employ?

A: We have a risk team that gives us all the data we need, providing us with access to tracking errors and so on. The fund’s realised tracking error has been about 4%, which is lower than our peer group.

Q: What does the portfolio yield?

A: As a whole the portfolio yields 20% more than the FTSE All Share. At present the yield is 3.6%, compared with a market yield of 3%.

Q: How high is turnover?

A: It all depends when the valuation gap you have identified for a stock has closed. If I see that a gap in a company’s valuation has closed and I can make better use of the money elsewhere, I will sell it.

Q: What is the one piece of advice you have picked up as a fund manager that you really stick to?

A: Not to shy away from doing all the proper work on companies beforehand. Once you have done this and have a high conviction in the idea, back yourself. There is no point doing lots of work just to take a small position. This has proved an important lesson for me, moving from managing institutional mandates to this, my first retail fund.

Daniel Roberts joined Morley Fund Management in July 2003 from Invesco Perpetual. Last August he took over the running of the Norwich Equity Income fund on an interim basis, following the resignation of former manager Scott McKenzie. At the end of February he took over as full-time lead manager. He also manages UK value satellite funds, Norwich Distribution and RBS Income. In addition, he has worked as a UK institutional equity fund manager at Invesco and as an equity analyst at M&G.